Going green through local fiscal equalisation

Success of centrally set environmental objectives requires the engagement of subnational governments. However, they often do not have the capacities or the incentives to apply ambitious climate mitigation and adaptation policies. Indeed, stricter environmental policies can lead to a decrease in local revenue collection as a consequence of the reduced activity resulting from the correction of externalities. To address this issue, in the line of Ecological Fiscal Transfers, we propose the inclusion of incentives linked to environmental objectives in local equalisation that would compensate for the opportunity costs faced by municipalities. In particular, we suggest greening fiscal equalisation by including a multidimensional index of local environmental performance that could be complemented by a green expenditure needs component as criteria for the allocation of equalisation grants. To illustrate how this proposal would work, we examine the financial effect that environmental fiscal equalisation would have had across Basque municipalities for the 2016-2019 period. As a main result, we find that less sustainable cities could lose up to the 5% of their per capita transfers, while small and most sustainable municipalities could win up to 13% of their per capita allocations.